With the advent of 24 hour a day trading the number of gaps that show up on the charts are not nearly as numerous as they were in the past. Still they are a very useful tool that way too many traders overlook. A gap occurs when a price bar opens and remains outside of the previous bars range.
There are 3 important types of gaps, a breakout, mid-point or continuation, and exhaustion. Breakout gaps usually occur when a market has been trading in a consolidation pattern, when suddenly price opens outside of that range and then takes off. The chart below shows three interesting gaps in April lean hogs. The initial gap at (A) first appeared to be a breakout gap but the market was unable to follow through to the downside. The market subsequently rallied and “filled” the gap at (B) negating its breakout status. A gap is considered filled when price retraces and trades through both gap extremes (high and low). To be considered valid, breakout gaps do not get filled. As you can see the breakout gaps at (C) and (D) were not filled and significant market weakness ensued.
DAILY APRIL LEAN HOGS
Continuation or mid-point gaps usually occur in the middle of a market move and often can be used to measure the expected distance the trend will ultimately travel. If you take the distance from the bottom of the first swing to the highest high prior to the gap, and then add that to the low of the gap day, you get a price projection of where price is expected to go. The sugar chart below shows an excellent example of a mid-point gap. The distance from the November low of 1113 to the high of 1534 just prior to the gap at point (A) is 421. Add that to the low of the gap day at 1543 and you get 1964. As you can see, in early February May sugar topped out at 1965, one tick past the projection! In order to be considered valid mid-point gaps, like breakout gaps, do not get filled.
DAILY OCTOBER SUGAR
Gaps can be very good indicators for prediction of price movement. Like anything in trading they are not fool proof, but they are a wonderful tool to have in a traders arsenel.